Investors advised to brace for “bond tantrum” in 2H; but yield pressure likely to ease in short term

• Yields expected to trend upwards in second half of year, on fresh concerns on reserves adequacy 

First Capital Research (FCR) recently said the current level of the massive amount of liquidity in the money market and the Central Bank’s continued support for government finances, by way of record level of Central Bank liquidity, would keep the bond yields in check for now. 

However, it advised the bondholders to brace for a “bond tantrum”, as yields could reverse course in the second half of the year.

By the end of last week, the excess liquidity in the money market was at Rs.130.5 billion while the Central Bank held Rs.874 billion worth of government securities, as a result of continued liquidity support to the government.  Sri Lanka’s bill and bond yields, which showed an upward push during February, eased after the Central Bank announced that it signed a US $ 1.5 billion swap arrangement with the People’s Bank of China, as it assuaged investor concerns about the sufficiency of the country’s reserves to meet its foreign currency liabilities. 

However, FCR maintained that the yields would trend upwards in the second half of the year, on fresh concerns on reserves adequacy, as the current foreign currency reserves, which got a boost from the US $ 500 million loan from China Development Bank in April, falls short of the foreign liabilities falling due in the next 12 months. 

FCR also compared the US $ 4.0 billion worth of foreign debt repayments falling due from April through December 2021, with the current US $ 4.5 billion reserves and the country’s limited access to foreign funding sources. That will all add up pressure on the bond yields, it expects. 

“Considering the surge in market liquidity, rate pressure may subside in the short term but brace for bond tantrums in 2H2021E,” First Capital said. 

FCR expects the bond yield band to increase by 50 basis points in 2H21. 

Besides the concerns of reserves and the country’s fragile external sector, inflation fears could also flock investors into bonds, sending their yields higher, as investors seek higher returns on safer assets that can beat inflation. 
Continued money supply when large swaths of people work at sub-optimal levels, due to virus-related mobility restrictions, could bring fresh worries over the prices, as a high amount of money with the absence of real productivity flares up inflation. 

And yields are inversely related to bond prices and thus the signs of rising yields could prompt bond holders to unload their holdings now at massive gains. 

In its latest update on the fixed income bonds, which provide guidance on the future yields, First Capital recommended the holders of bills and bonds of three months to seven-year tenures, which are typically referred to as short to mid-tenure bonds, to sell them while the others with eight years to 20-year bonds to hold them. 

In a March report, ICRA Lanka Ratings said that the reining in bond yields is crucial for keeping the market lending rates in check. 

On the contrary, the market lending rates have continued their descent, reflecting a disconnect between the perceptions of the bond investors on the economy and the broader market participants. 

The Monetary Board in its April Monetary Policy made explicit of this disconnect and said that upward pressure on government securities was in contrast to the monetary policy expectations and reiterated the necessity to maintain a low interest rate structure amid significantly high excess liquidity in the domestic money market.